Category Archives: Economy

The Return of the ’97/’98 Playbook

My long-term bullish outlook on US stocks is predicated on a US economy that continues to strengthen in the face of a global slowdown. This has happened before. FT Alphaville compares the current period to 1997/1998:

Recall what things were like in those heady bygone days:

  • Oil prices had plunged by nearly 60 per cent from the start of 1997 through the end of 1998
  • Spreads on high-yield bonds had widened by about 4 percentage points in 1998, while spreads on the junkiest junk debt had widened around 6 percentage points
  • Currency crises and deep downturns were afflicting poorer countries from Latin America to Russia to Asia
  • The US dollar had rocketed up more than 20 per cent from the start of 1997 through the end of August, 1998
  • Core inflation had slowed from an annual rate of 2.0 per cent in June, 1997 to just 1.0 per cent by June, 1998 — the slowest rate ever recorded until 2010
  • America’s unemployment rate had dropped by a percentage point to levels not experienced since March, 1970

Now compare to what we have now:

  • Oil prices are down about 65 per cent since mid-2014
  • Spreads on high-yield bonds are up around 3 percentage points since the start of 2014, while the spreads on debts rated CCC or lower have widened by nearly 9 percentage points
  • Many large emerging markets, including Brazil, Russia, Turkey, and China, are either shrinking or slowing down sharply
  • The dollar is up nearly 20 per cent since the summer of 2014
  • Core inflation slowed from an annual rate of 1.7 per cent in July, 2014, to 1.3 per cent ever since the start of 2015
  • America’s unemployment rate has dropped by a whopping 1.6 percentage points since the start of 2014

As it pertains to stocks, there are a couple of important differences: currently, US economic growth is slower and interest rates are much lower. In my view, both variables cancel each other out in their effects on equity valuations. In 1998 US stocks shook off a 20% correction to go on a parabolic (and unsustainable) run based on earnings growth and multiple expansion. I believe history will repeat itself, although stocks may experience more modest gains and the current bull market will last longer.

With regards to numerous recent predictions about a US recession, it seems that they have mostly been based on the recent weakness in manufacturing activity. But it is important to keep in mind that the US economy is primarily driven by services, while manufacturing’s share is less than 10%.

US Employment by Sector
Source: The Economist

And as reported by the ISM, manufacturing is contracting while services is expanding healthily. If the 1998 playbook is followed, then the manufacturing sector will soon return to growth.

Manufacturing and Services Decoupling

Therefore, if US economic growth continues to chug along and it turns out that investors’ fear about a recession were misplaced, then as in 1998, the maximum possible drawdown that one should expect is limited to around 20% and the bull market will shortly resume.

US Economy Ready to Heat Up

Later this week the Bureau of Economic Analysis will report that the US economy wrapped up its 5th consecutive year of GDP growth. Since the average post-war expansion has lasted 5 years, it may feel like the current expansion is getting long in the tooth. However, rather than looking for a recession, I am of the view that the economy is on the verge of accelerating.


The chart above shows that although the economy has expanded in recent years, growth has been below average due to household deleveraging. But there are indications that US households are beginning to borrow again. First, the household debt to disposable income ratio has returned to the lowest levels of the previous decade. And the stronger balance sheet has allowed household liabilities to increase again.

US Debt

When consumers increase borrowing, they are also increasing spending. Since personal consumption makes up two-thirds of the US economy, faster consumer spending can spark faster GDP growth.

In addition to consumption, residential investment is an important driver of economic growth. As I detailed in a recent post, housing starts are set to pick up which can be a tailwind for the economy.

Residential Investment as a % of GDP

In sum, I am expecting consumer spending and housing to help push US GDP growth to 3%+ for the next couple of years.



What Caused the Bust?

Marc Faber, who predicted the economic and financial crisis, has written an excellent piece in today’s WSJ blaming government policies rather than the free market for getting us into the current predicament. Because of the government’s ineptitude he believes that the best solution is to do nothing and allow the free market to sort out the mess.

Don’t Worry Mr. Market! More Rate Cuts Are on the Way

As expected the Fed reduced by 25 basis points the funds rate to 4.25% and the discount rate to 4.75%. The stock market tumbled immediately after the announcement because there was hope that the discount rate would be cut by 50 basis points. Moreover, investors seemed to be concerned that the FOMC statement didn’t signal additional future rate cuts.

For example, Jim Cramer vented his disapproval saying, “a simple 25 basis points more would have made a tremendous difference for the economy’s psyche. It would have showed the Fed is on the case.” Although the Fed’s policy decision disappointed Cramer and the market, I believe many more rate cuts will be delivered next year – more than investors are expecting – though some would argue that it would be too late.

Currently, the futures market is pricing in a Fed funds rate of 3.25% by December 2008. I am willing to take the under on that bet. With eight FOMC meetings scheduled for 2008, I think it’s likely that we will see a two handle on the funds rate at some point next year. Let me explain.

I will concede the Fed is very concerned about inflation: they have expressed this whenever a microphone is put in front of one of its members. And it is why they didn’t deliver a 50 basis points cut yesterday. They are concerned because I am sure that they are not foolish enough to believe the CPI — after all, former Fed governor, Alan Greenspan, played a major role in its dubious construction.

But in the their view, high inflation is not necessarily problematic as long as long-term inflation expectations don’t rise. That is, if people don’t doubt the dollar’s purpose as a store of wealth, the Fed can print a lot of money and stimulate the economy. This makes managing inflation expectations critical, especially in the current environment of slowing economic growth where money printing would be useful. Thus, the rationale behind all the hawkish talk about inflation, while in practice they cut rates.

So although the Fed would rather not ease monetary policy, a weakening economy is forcing them to do just that. And the economic picture is going to get bleaker. Residential real estate, with high inventory levels and home affordability declining, will continue to suffer falling prices. This will exert a drag on consumer spending, which amounts to 70% of GDP, and therefore on the economy. Lower rates won’t lead to greater corporate spending either. Business investments have been sub-par even when the economy was strong, so it is unlikely to pick up in pace as the economy weakens.

In the last recession, the Fed had to reduce the funds rate to 1% to stimulate growth. That was a capital spending led recession. This recession is being led by real estate investment and consumer spending which are more meaningful to the economy. It would therefore be unlikely that a downturn can be overcome this time around with an easier monetary policy than implemented during the previous, more mild recession.

Now while I think the Fed will bring down rates more than consensus expectation, I am not suggesting this is the right thing to do. Actually, if I had my way the Federal Reserve would be abolished, but that’s a topic for another time. My belief is that an accommodative monetary policy is the wrong approach to dealing with the current economic problems — akin to giving more heroin to a heroin addict.

The money supply, as measured by M3, is growing at 16% annually: inflation is clearly a big threat to the economy, though its impact may take a while to be felt. The Fed, with the urging of Wall Street and Capitol Hill, will continue to lower rates which would help dealing with the near-term credit crunch, but will make the eventual day of reckoning more painful.

The US economy has a fundamental and serious structural problem: too much debt. That is, the greatest challenge the economy faces is servicing the existing debt, not access to additional debt. The cure for this is to let the market work by forcing bankruptcies and having the debt written off. A deflationary recession would ensue marked by declining corporate profits, job losses, and falling asset prices. Although this would be a harsh experience for most Americans, eventually the economy will be cleansed of distortions and it can get back to robust growth. Wouldn’t be nice to attain a 7-8% long-term growth rate rather than the 3-4% that we yearn for now?

However, the loose money stance the Fed has adopted actually makes the problem of excessive debt worse by encouraging more borrowing. Perhaps if the Fed prints enough money the debt will become worthless. In any case, the result will be that the economy should avert a severe deflationary recession in the short-run, but there won’t be smooth sailing either. As discussed before, home prices will be declining for a very long time, providing a substantial drag on consumer spending.

The excessive money creation stimulated by the Fed will rather spill into consumer prices, particularly food and energy. Thus, stagflation will be the likely result. Eventually inflation expectations will start to rise, and if Fed monetary policy isn’t altered, inflation will reach excessive levels — dare I call it hyper-inflation — and the whole monetary system will collapse leading to the deflationary depression that we are trying to avoid. I can’t put a timetable on this, but it’s a textbook pattern that has been played out frequently in history. I hope to expand on this point in a later blog post. So how does one protect oneself from all of this? My choice is gold.

Economists Never See Recessions Coming

The US economy is clearly slowing down and I believe a recession is inevitable. Wall Street economists have increased the odds of a recession occurring over the next 12 months to 36.3%, which means, as a group, they still think a near-term economic contraction is unlikely. I concede that these economists are better educated and more experienced than I am, so I have to question myself. What could make me more prophetic than the pros?

I take comfort in the fact that economists have never correctly predicted a recession. Here is data going back to 1973:

Mozilla FirefoxSource: Merrill Lynch

Their poor track record of forecasting recessions can be explained by the rarity of recessions. An economist has been right more often than not when he forecasts 2-3% expansion which has been the long-term growth rate of the US economy. When he forecasts a recession, the odds are against him being right. So he will stick with the safe bet.

Even when he sees strong indications of a forthcoming contraction, if his peers fail to express the same pessimism, he, too, would unlikely do so. The difficulty in being a contrarian is that economists are aware of each other’s forecasts and have a natural herd mentality. If an economist were to stray from the herd by predicting a recession and the forecast turns out to be incorrect, career prospects would become sour. On the other hand, if he followed the crowd and missed calling a recession, he would be no worse than his peers.

As someone who is not employed in the securities industry, I suffer no such risk when going against the crowd. And in my short career as an individual speculator, I have found that being a contrarian can be far more rewarding.

Jobs Data Suggests Recession is Near

The August nonfarm payrolls data caught many people off guard when it showed the economy shed 4,000 jobs during the month. This was the first loss in 4 years. And to add insult to injury payrolls for June and July were revised down by a combined 81,000 jobs. The large revisions are one of the reasons I ignore the freshly reported payrolls figure.

Many bulls believe the economy will continue to perform well because unemployment is at very low levels which should lead to growth in wages and consumer spending.

St. Louis Fed_ Series_ UNRATE, Civilian Unemployment Rate

However, as the above chart shows, the unemployment rate is a coincident economic indicator. Therefore, when the unemployment rate is low, as it is now, it merely suggests that the economy has been doing well, but by the time we realize that it has reversed higher, the economy is already in a recession.

Also, the unemployment rate, by definition, may not give an accurate picture of employment. Here is how the unemployment rate is calculated:

Unemployment Rate

The unemployment rate can decline when the number of people employed increases, which has been occurring based on the payrolls data of the last few years. But the unemployment rate can also fall when people leave the labor force, most likely due to difficulties in finding satisfactory work. The following graph plots the civilian employment – population ratio (EMRATIO) to strip out changes in the labor force.


Adam Oliensis makes the following comments regarding this chart:

What makes itself apparent to my eye is that any time the EMRATIO has fallen by as much as 0.5% from a local high it has fallen much further than that (usually 2-3%) and any time a fall of that magnitude has occurred there has been a recession.

The EMRATIO has now fallen about 0.6% since its peak in December 2006. So, if the “forces of nature” that have governed the economy continue to operate as they have over the past 50-60 years, it looks like we’re in for a larger fall in the EMRATIO (2-3%) and for a recession.

Interestingly, the EMRATIO, like the unemployment rate, has historically been a coincident indicator of economic growth. But this year the EMRATIO has been falling, while the government’s GDP report shows positive growth. Perhaps the GDP report would paint a recessionary picture if inflation was properly calculated. In any case, the EMRATIO debunks the bull case that the employment market is strong.

The ‘Financialization’ of the US Economy

A couple of insightful posts by Sudden Debt here and here elucidate how dependent the US economy has become on a growing financial sector:

About 20% of S&P 500 by capitalization and 30% of earnings are made up by financial shares. Add the finance arms of industrial cos. like GE, GM and Ford and some 35-40% of all S&P 500 earnings are made up of purely financial activities. Not exactly happy times there, right now.

Corporate profits have been able to rise 12% a year since 2002 thanks to robust financial earnings:

Profits Likely to Slow in _07 - WSJ.comGraphic by

But as the following graph shows, financial companies have used increasing leverage to grow earnings:

Sudden Debt_ The Rabelaisian Growth of Financial DebtGraphic by Sudden Debt

If the current liquidity crisis persists for a while longer, then financial earnings will no longer rise and may actually decline. And I don’t see how the S&P 500 will rise to new highs if its most important sector is contracting.

High-Income Consumers to Rein in Spending

Consumer spending although not robust, has been growing despite the ongoing recession in the residential real estate sector. I have suggested some possible reasons why there is a lag between when the housing bubble started to collapse and when we would see a substantial decline in consumption.

But another important factor which I failed to mention was the healthy spending by high-income individuals who do not concentrate most of their net worth in their homes, like most Americans do, but have significant holdings of bonds and equities in addition to real estate. Therefore, when home prices fall their wealth is not affected as much, and as a matter of fact, the luxury property market has been doing quite well.

Based on the most recent Federal Reserve’s 2004 Survey of Consumer Finances and the BLS Consumer Expenditures in 2005, those in the top 20% of the income distribution hold 91% of common stocks, 91% of non-equity financial assets, but only 65% of real estate equity. And they account for approximately 40% of total consumption.

During the last few years, stocks and fixed income assets had fared quite well and, not surprisingly, the rich have stepped up their consumption as can be seen in the results of high-end retailers. However, the current liquidity crisis has hurt asset prices and if they do not recover quickly, then the wealthy will pull back on their spending.

As an aside, Wall Street has been coining money as asset prices have risen in the last few years and employees have been handsomely rewarded. For instance, according to Bloomberg during 2006 the big five investment banks paid out $36.5 billion in bonuses and the 25 best-paid hedge fund managers earned over $14 billion. That is a total of over $50 billion — nearly as large as the GDP of Vietnam, a country with a population of 85 million.


With only a few months left before financial firms begin their year-end payout discussions, it appears as though bonuses will not be nearly as lucrative as they have been in the recent past. I will be paying close attention to the results of Coach (NYSE: COH), Nordstrom (NYSE: JWN), and Sotheby’s (NYSE: BID) in the coming quarters. If their reports indicate that the wealthy have cut their spending, then overall US consumption could suffer an outright decline.

America is a highly indebted economy, which is not an issue if asset prices are rising. But if asset prices stop rising then servicing the debt becomes a problem and spending needs to be curtailed. Wal-Mart’s (NYSE: WMT) recent results show that low- and middle-income consumers are already tapped out. Expenditures from the high-income consumer may be the next shoe to fall.

The World Should Fear a US Slowdown

I am in the camp that believes the US will soon enter a period of economic stagnation or recession, which will significantly cut growth in most parts of the world. To elaborate, I am posting the following excerpt from the recent Quarterly Review and Outlook, Second Quarter 2007 from Hoisington Investment Management:

It is incorrect to believe that the rest of the world is strong enough to boost our exports and keep our economic activity on an even keel in the face of a slowdown in U.S. consumer spending. Importantly, real exports constitute only about 11% of economic activity, versus 68% for real PCE. Thus, a massive lift in exports would be needed to keep the economy expanding in the face of consumer retrenchment. However, the statistics and economic history suggest that world growth causality runs from the U.S. to the world, not vice versa. The World Bank provides a breakdown of world GDP in real terms (Table 1).

HIM2007Q2NP.pdf (5 pages)

At present, the world is a mix of rapidly growing and significantly underperforming economies, with the BRIC (Brazil, Russia, India, China) countries on the high growth side and Japan, the United States, and those closely aligned with the U.S. on the slow side. The rest are largely somewhere in between these strong and weak groups. The United States accounts for 31% of world GDP with Japan next in line with 14.1%, meaning these two countries account for 45.2% of total world output. The BRIC countries, on the other hand, control 10% of global output. Although Mexico and Canada diverge from the United States over shorter intervals, over the long run they are tied to the fortunes of the United States. Adding those figures to the United States and Japan boosts the total to 49.3% of global GDP, a figure that easily rises to about 50% if one takes into account the Latin American countries influenced more by the United States than any other country.

But even this analysis is not a complete description of the impact of the United States on the global economy. A main source of Chinese growth is their burgeoning trade surplus, most of which is with the United States. According to official Chinese figures, the Chinese had a record trade surplus for the first half of this year of $112.5 billion, with $73.9 billion or 65% with the United States. U.S. records indicate that its deficit with China is bigger than the official Chinese figures show. The boost to Chinese GDP is even greater when one takes into account the foreign trade multiplier, or indirect economic effects. It then becomes clear that the Chinese trade surplus against the U.S. has been a powerful stimulant to their economy. They will indeed feel the slowdown in U.S. consumption. The U.S. trade deficit also plays a major role in domestic economic growth for India and Brazil, not to mention Europe.

Econometric studies provide important insight into the global impact of the U.S. economy. These studies have shown that U.S. imports increase $2 for each $1 rise in income, but that U.S. exports go up just $1 for each $1 gain in foreign income. Thus, when U.S. consumption is accelerating the world economy is a major beneficiary, but when it slows, as it is now doing, the rest of the world will lose forward momentum. This relationship explains why U.S. domestic demand leads the domestic demand in the large foreign economies by six to nine months (Chart 3).

HIM2007Q2NP.pdf (5 pages)-1

In the second quarter real domestic final sales slumped in the United States and U.S. imports fell, aligning with the econometric studies. Industrial production has contracted for three straight months in Japan, and Germany registered a net decline over the past two months. Thus, the process of transmitting U.S. weakness to the rest of the world has begun.

Investors holding foreign stocks hoping for protection from a US economic contraction might be disappointed.

A Credit Crunch in a Highly Leveraged Economy

The collapse of the subprime mortgage market has caused fixed income investors to demand higher risk premiums from not only all grades of residential mortgage-backed securities, but also commercial mortgage-backed securities, corporate bonds and debt from emerging markets.

Treasury yields, on the other hand, have been declining due to a flight to “quality” creating wider interest rate spreads. However, as the following graph shows, spreads are still low by historical standards:

High Yield SpreadsSource: Bear Stearns

But I am still worried because a record amount of non-government debt is required to create each unit of GDP.

US Debt to GDPSource: Federal Reserve

Therefore, rising interest rates can induce a monetary contraction that can have a bigger impact on the economy than in the past. This is why the current credit crunch should be closely watched.